What Does Basel III Mean for Gold and Silver? (2024)

The Basel Accords

The Basel Committee on Banking Supervision (BCBS) was set up in1974 by the central banking governors of the Groupof Ten countries in order tomaintain oversight of global banking standards. These principles are high-level but are non-binding. This means thatmembers are not obliged to maintain standards but are certainly expected to.

Basel I & II

In 1988,the BCBSrecommendedthe implementation of minimum capital requirements for banks.Assets were classified and ranked according to their credit risk. For example, assets like cash, physical bullionand treasury bonds were given a zero-risk rating,AAA-ratedmortgage-backedsecurities (MBS) were considered fairly low risk at a rate of 20%, withthe riskiest assets like corporate debtgiven a 100% risk rating.

Theserecommendations were gradually implemented over time with over 100 countries coming to adopt theaccords.

An intermediate Basel 1A was proposed which would have been more risk-sensitive than the originalaccord. This was dropped in order to allowthe implementation of Basel IIwhichwasthrough a “three pillar” approach to banking regulation. These pillars focused on:

1. Minimum capital requirements – which looks at credit risk, operational risk and market risk
2. Supervisory review–this gives regulators the tools to oversee pillar 1 andtake into accounta number of other riskcategories
3. Market discipline-a set of disclosure requirements which would allow market participants to assess thestability or capital adequacy of an institution.

Basel III

For some, the Global Financial Crisis (GFC)of 2007-2008 showed some of the flaws in the Basel Accords and that stricter regulation would be required. For others,Basel II, in part, exacerbated the crisis due toitsmicromanagementandbureaucracy.

The BCBS agreed on the new Basel III regulationsin2010, however, implementation has been delayed a number of times.

Existing risk management systems proved ineffective against unforeseen stresses like those seen in the GFC.The Basel Committee acknowledged these shortcomingsbutrecognisedthat a lack of governance was also partly to blame.

TheNet Stable Funding Ratio (NSFR)“aims to promote resilience over a longer time horizon by creating incentives for banks to fund their activities with more stable sources of funding on an ongoing basis.”

This NSFR is essentially, a liquidity requirement that banks must adheretotocover their longer term, less liquid assets.

Basel III and Gold

The NSFRis calculated using the proportionof an institution’s Available Stable Funding(ASF), which refers to its liabilities, andits Required Stable Funding(RSF) which is applied to its assets.The ratio between the ASF and RSF must always be over 100%, meaning all of their liabilities covered by their assets.

According to the London Bullion Market Association (LBMA), the problem lies in the classification of unallocated liabilities, like unallocated gold and silver are given anASF ratio of 0%, while unallocated gold assets are only worth 85% of their market value.Unallocated metals, which are an essential form of liquidity,are in some respects devalued by the new rules.

What is the Likely Outcome of the New Basel III Rules?

This meansbanks will need to set aside more funding for unallocated gold and silver otherwise, oras some have suggested, the end offorwards and futures contracts for precious metals.

Unallocated gold, as Alasdair Macleod writes is“no more than book entries tied to the price of gold, and its origin and continued existence is entirely funded by the creation of bank credit.”

In a May 2021 article, Macleod points out thatCOMEX is currently shortaround $24 billion in gold futures contracts. As European banks willlooking to have their short positions covered in the next 6 weeks, there will be considerable pressure for COMEX to fulfill these orders.UK banks will face similar rules when Basel III rules are enacted in January 2022.

The effects of the rulings on the physical market are also up for speculation. Physical bullion is still classed as a Tier 1 asset so little changes in this respect.It would most likely depend on if and how they reallocate theirpositions. It is believed by some that the paper gold markets have helped suppress the gold price through theexpansion of contracts based on bank credit. If institutions shift out of paper gold andturn their attention to physical gold, this could mean a huge breakout in the gold price as the new demand meets supply.If,however,these institutions move out of gold entirely,a sharp price drop may also be possible.

Conclusion

While Europe,and soon the UShave implemented the new regulations, the UK is expected to start from January 2022.Proposals forBasel IV, which is said to “complement” Basel III,were agreed in 2017 and are due to be implemented in 2023.

Economists from various schools havecriticisedthe Basel reformson grounds ranging from the regulatorsinability to spot the last financial crisis to theinadequacy of central banks’ stress tests. As John Carney wrote in 2013:

“Neither the bankers nor the regulators understand how our last financial crisis was engineered...Which makes it very hard to take seriously their claims that the new rules the regulation peddlers have pulled from their sack will do very much to create a more resilient financial system.”

The new rules will no doubt have some consequences on the gold markets and financial markets in general.What is unlikely, is that they will prevent any future crisis like the GFC. We are (hopefully) coming out ofa yearlong lockdown, the full effects of which have yet to be seen. At best, Basel III may be a case ofshutting the gate after the horse has bolted. In which case, it wouldn’t be surprising that after Basel IV we’ll see more reformsthan Fast & Furious films.